Chris Whalen Gives 6 Reasons Why The Next Bubble Will Be In Structured Notes

Structured notes, derivatives packaged with bonds, might be the cause of the next bubble, says a new paper published by Christopher Whalen, managing director of Institutional Risk Analytics.

Bloomberg reported on the paper, which says that structured notes are derivates-based products (packaged with bonds) sold to investors looking for higher yields. That's the first red flag, meaning that the notes are risky investments that may pay off very well.

"The firms originating these ersatz securities, as with the case of auction-rate municipal securities, have no obligation to make markets in these OTC structured assets or even show clients a low-ball bid." (So they're expensive and firms selling structured notes might not be hedging their bets or balancing their exposure to the risk.)

And now for even worse news:

Sales of the securities to individual investors in the U.S. rose 72% from a year ago to $29.6 billion through July, according to StructuredRetailProducts.com

Whalen says he knows of at least two hedge funds are already being established specifically to buy the notes from distressed retail investors as interest rates start to rise (their value is partly derived from bets on interest rates)

Keith Styrcula, chairman of the Structured Products Association, a trade group that organizes industry conferences said that "firms make clear in the prospectuses that they are under no legal obligation to provide liquidity."

But he added: "they have provided it over the last two decades without a single hiccup."

As soon as benchmark interest rates rise, Whalen predicts that investors in structured notes are going to lose money.